Q&A
Explore Your Options
Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the Stocks & Commodities website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C.
Volatility Risk
A stock I like has been trending higher, and I was considering a credit spread expiring in May. However, the earnings report is due May 7 and I can’t determine whether this volatility rush will negatively affect my position… any advice for me?
You are correct, knowing the earnings reporting date when trading individual stocks can be very important. In addition, there is often a volatility rush ahead of earnings. In other words, the implied volatility (IV) of the options will begin to move higher prior to the earnings release. Why?
The market is very efficient when it comes to anticipating future volatility. When a stock is expected to make a big move, the option premiums become more expensive because big moves make it more likely that an option can move in-the-money by expiration.
For instance, a call option with a $110 strike price on stock A, which is currently quoted for $100 per share and has been trading in a five-point range for the past six months, is going to be less valuable than the same option contract on stock B, which is also trading for $100 per share but has been trading in a 25-point range. It is much more likely that stock B will move above $110 by expiration and that call option will be in-the-money. All else being equal, higher volatility results in higher option premiums.
Option premiums are always changing to reflect volatility expectations. Within each option contract, the changes in premiums are due to changes in IV. Consequently, since stocks often make big moves around earnings, implied volatility normally increases ahead of the reports. The IV increase is known as a volatility rush. But after the earnings report has passed, IV normally falls; that is known as volatility crush.
When dealing with at-the-money credit spreads, the most important factor that will determine the success or failure of the trade is not volatility, but the price action of the shares. For example, if the stock is trading around $45 and I sell the (at-the-money) May 45 puts for $4 and buy the May 40 puts for $1.50, I sold the May 45 - 40 put credit spread for $2.50 ($4 - $1.50 = $2.50). If so, I want the stock to stay above $45 and both contracts to expire worthless, which would mean I keep the credit. If the stock falls, I can begin to run into problems as my spread will widen and my trade begins to lose money.
Implied volatility around earnings can have a minimal affect on the position (see the next question). In addition, in your example, the report is on May 7 and the options expire on May 15. Chances are the earnings-related volatility rush has already been crushed by expiration. The more important consideration will be how the stock reacted to the news — did it move higher or lower? Ultimately, the direction of the stock is the most important determinant for the success or failure of a credit spread.
Creating Credit Spreads with High Volatility
I have read that credit spreads are good for high implied volatility situations, but I am slightly confused. By virtue of it being a vertical spread, doesn’t that almost nullify the benefit of the high implied volatility and high premium situation? My feeling is that credit spreads mainly take advantage of time decay rather than an expected drop in IV. Any thoughts would be greatly appreciated.
Vega is one of the option greeks that will tell you how much the value of an option will change for each change in implied volatility. For example, if I buy a May put with the 45 strike and the vega is 0.05, I know that the value of the options will increase by $5 for every point move in implied volatility. However, if I sell the May 45 put, the position will decrease in value for every one-point increase in implied volatility. Long options have positive vega. Short options have negative vega.
One of the great things about vertical spreads is that they are very close to vega (volatility) neutral. If I sell the May 45 put with a vega of 0.05 and buy the May 40 puts with a vega of 0.04, my overall position vega is only 0.01. A rise or decline in volatility will have a minimal effect on the trade compared to other strategies.
Consider the straddle. Many inexperienced option traders think that buying straddles (both puts and calls with the same strike price) before an earnings announcement and selling the position when the implied volatility is high just before the announcement is made is a great strategy. They attempt to capture the increase in IV by purchasing both puts and calls and staying neutral with respect to price. In doing so, they are thinking of a straddle in terms of volatility levels alone. Sometimes the implied volatility will be going up, but the price of the straddle will not. What is at work here? Answer: Time decay.
The straddle is losing money every day due to time erosion. Changes in IV and time decay are offsetting each other. So clearly, IV is not the only factor to consider when creating credit spreads. The position is not going to be extremely sensitive because the position has both long options (with positive vega) and short options (with negative vega).
The more important factors that will affect the trade are: 1) the price of the underlying asset, and 2) the impact of time decay. Theta is the greek that measures the impact of time decay and, since I have run out of space, will be a topic for discussion in a future installment of “Explore Your Options.”